Understanding convertible loans: a founder’s guide

For startup founders, raising capital often means choosing between speed and flexibility versus complex equity negotiations. Convertible loans strike the perfect balance—they’re fast, adaptable, and defer tough valuation decisions until your company grows.

Understanding convertible loans: a founder’s guide will help you understand how convertible loans work, their advantages, and their challenges and how to leverage them.

Convertible loans are a hybrid financing tool: they begin as debt but are designed to convert into equity (shares of the company) at a later stage. This setup provides startups with a quick and efficient way to raise funds without immediately deciding on a valuation.

Compared to equity financing, convertible loans involve less administrative complexity—skipping lengthy negotiations, legal formalities, and regulatory steps like registering a capital increase. This simplicity makes them an ideal choice for bridging funding gaps between equity rounds.

Convertible loans provide an elegant solution for startups navigating key challenges:

Bridge financing: Fill the gap between equity rounds when your company hasn’t hit milestones required for the next round.
Cash runway extension: Stretch your budget without locking in a valuation for the company.
Quick cash injection: Raise funds rapidly during macroeconomic crises or seize unexpected growth opportunities.

Understanding how convertible loans differ from equity financing is crucial for founders:

Convertible loans appear on the balance sheet as liabilities, with investors holding creditor status. Unlike equity financing, where investors have immediate decision-making power, convertible loans convert into shares at a predefined point, such as a future financing round. This delay gives startups flexibility while rewarding investors with discounts or interest.

Convertible loans aren’t just for startups in financial trouble. Here are two scenarios where they’re particularly effective:

1. Strength under pressure: If your company hasn’t reached its growth targets or needs more time to hit milestones for a new equity round, a convertible loan provides the breathing room to execute your plans.
2. Raising capital quickly: If your company is performing well but you need capital urgently to scale or meet demand, a convertible loan lets you secure funds without lengthy discussions about valuation.

1. Faster process: Equity rounds can take months, involving multiple investors, lawyers, and regulatory filings. Convertible loans streamline this process, delivering funds quickly.
2. Deferred valuation: Postponing valuation decisions allows you to grow without risking a down round.
3. Strategic flexibility: Use the funds to achieve milestones that strengthen your position for future equity rounds.

While convertible loans offer many advantages, founders should be aware of the potential trade-offs:

1. Dilution: When converted, these loans dilute your ownership. It’s crucial to calculate the impact carefully to avoid surprises.
2. Investor control: Convertible loan investors don’t gain voting rights until their loan converts. If you need active involvement or strategic input from investors, equity financing might be more appropriate.
3. Complexity at conversion: Issuing multiple convertible loans can complicate cap tables, making future equity rounds harder to negotiate.
4. Misaligned expectations: Clear communication with investors is essential to avoid disputes over conversion terms or valuation caps.

Use this quick checklist to decide if convertible loans align with your goals:

To maximize the benefits of convertible loans, consider the following:

1. Negotiate wisely: Strike a balance between terms that attract investors and those that protect your long-term interests.
2. Engage trusted advisors: Work with experienced lawyers and financial advisors to craft clear, fair agreements.
3. Focus on milestones: Use the funds strategically to achieve key growth targets, making your company more attractive for the next equity round.

Understanding the terms of a convertible loan is crucial to protect your interests and attract investors. Here are the most common terms and what they mean:

Discount: Investors typically receive shares at a reduced price (e.g., 10–20% off) during the next equity round, compensating them for early-stage risk.
Valuation cap: A maximum valuation at which the loan converts into equity. This ensures early investors benefit from their risk, even if your valuation skyrockets.
Interest: Convertible loans often accrue interest, though rates are typically lower than traditional bank loans. This interest is usually paid in equity upon conversion.
Qualified financing: The minimum amount of funds raised in the next equity round that triggers the loan’s conversion into shares.
Maturity date: If no qualified financing occurs by this date, investors may choose to convert their loan into shares or request repayment.
Change of control: If your company is acquired or merges before conversion, the loan typically converts into shares at a predefined discount.

Convertible loans are a versatile financing tool, offering startups a quick, efficient way to raise capital while deferring complex negotiations on valuation. Whether you’re navigating a challenging period or seizing an opportunity to scale, these loans can be the bridge to your next big milestone.

As a founder, success lies in the details. Understand the terms, choose the right partners, and use the funds strategically. Your startup’s future depends not just on securing capital—but on using it wisely. With the right approach, a convertible loan could be your startup’s ticket to bigger opportunities and long-term growth.